December 14, 2012; War is Upon Us

Kevin: David, a few weeks ago we talked about wars being fought just a little bit differently, both militarily, but also currency wars where you have people who are actually competing to devalue their currency to gain business from other countries that may have stronger currencies.

David: On the one hand it is no surprise that we are seeing the topic in the Wall Street Journal this week, but it is important who is commenting on it.

Kevin: Yes, it’s the Bank of England, I think, isn’t it?

David: That’s right. Governor Mervyn King – and this is from Jon Hilzenrath’s article earlier this week – has warned of the risk of currency wars in the coming year as nations search for new ways to spur their economies in a world of slow growth and few other options. Reading here from the Wall Street Journal, as they report, “A cheap currency, in theory, makes exports more competitive, and thus, helps to spur economic output.”

This was the speech that Governor Mervyn King was giving at the Economic Club of New York, and then in an interview with the Wall Street Journal.He said, “I do think 2013 could be a challenging year in which we will, in fact, see a number of countries trying to push down their exchange rates. That does lead to concerns. Will other countries react in kind? What will happen?” Mr. King said in the interview, “The policies pursued by countries for domestic purposes are leading to tension, collectively.”

Kevin: David, I think we should point out that this is actually being considered a policy tool. These are active decisions to push a currency down. The thing that is just so sad about that is, for the person who saves money, actually has that particularly currency, it just destroys the buying power of that currency. Granted, it may make that country more competitive. It might even add to the employment of that country, but it kills the saver, doesn’t it?

David: It goes back to one of the things that we’ve talked about many times. You can’t just simply look at economics and some sort of an economic calculus. You have to look at things from an interdisciplinary standpoint to really understand what is happening today. This is a domestic fiscal policy which has international political consequences and that is why this is a really big deal.

It really is a big deal, because you are not talking about a war, with tanks and bombs and guns, you are talking about weapons that are financial and economic in nature, but they still have a political and geopolitical calculus.

Kevin: And they seem to have even more of a widespread outcome than a military war. Let’s face it, Dave. Here on our own shores the Federal Open Market Committee, and the Federal Reserve, they’re doing the same type of thing, aren’t they?

David: They meet this week and they are expected to extend operation Twist, with a few changes necessary, as they are actually running out of the short-dated paper which they have been using to swap for the long-dated Treasuries, and thus, suppress or drag down the long-term Treasury yield.

Kevin: Let’s stop there for a second. They are running out of short-dated paper. Isn’t there enough paper out there to satisfy the Fed’s need?

David: Operation Twist was different than other quantitative easing measures because it was considered “balance sheet neutral.” In other words, they were just swapping one piece of paper for another and they weren’t seeing growth in the balance sheet in question. Coming into 2013, there is a certain expectation that they move not only to extend Twist in some degree, and again, that’s the balance sheet neutral part, but there is more and more discussion that they may expand their balance sheet to 4 trillion dollars from the current 3 trillion.

Kevin: How is that neutral?

David: That’s not neutral at all, and I think that’s where we are moving into dangerous territory. If you look at the balance sheet of the Federal Reserve, not the New York Fed because their leverage is off the charts, but if you look at the collective member banks of the Federal Reserve System, they are currently leveraged at over 50-to-1. What they are talking about doing, if they do move to 4 trillion dollars, you are talking about a 66-to-1 leverage.

Kevin: Even at 50-to-1, that means you have two bucks down for every hundred that you are talking about risking.

David: That’s right, because it is only 2% volatility, where the portfolio of assets they hold drops by that amount, 2%, and it wipes out their capital base. We ultimately see the balance sheet expanding to 5 trillion, and that’s, I think, before our international creditors figure out that an “exit strategy,” and I put that in quotes because that is what they have always put in quotes. The Fed believes they can still exit from this kind of an asset purchase program and that exit strategy, we think, is going to be impossible.

As they attempt to do that, we think our foreign creditors are going to get out in front of the Fed. In terms of liquidations, before the Treasury market begins to implode and interest rates increase, you’re going to see market activity that is way out in front of the Fed exit strategy.

Kevin: We’ve talked about this before, David, that you can have creeping inflation, you can have inflation that even gets to be relatively high, but there is a moment when people no longer want to hold the currency, when it looks like it can’t be supported anymore. We don’t know when that moment will come. It’s probably hard to understand the trigger point, but it’s out there.

David: What you are really talking about is a cusp event, where you have a certain degree of pressure that exists in the system already and what is the precipitating event? We live here in Colorado. We have no snow, so this is maybe a bad example at present, but we are really hoping that by the end of December…

Kevin: I know where you are going because you have been near, or almost on, an avalanche in the past, and you understand there are signs, but you don’t know exactly when it’s going to let go.

David: Is it a snowflake? Is it a bird fluttering by? Is it a climber? Is it a snowmobile? There are a number of things that can cause the natural state of instability to trigger and become an uncontrolled event. That is, I think, where people are not assuming, and economic departments don’t assume it, because they can’t figure it out. It is a sociological, not economic, and it is a psychological, not an economic, event, and their models only deal with economics. It is very interesting because over the last few years the frustration of economists has led to a brand new field as a subset to economics, what you call behavioral finance.

Kevin: It’s like psychology.

David: It really is. But to look at the financial decision-making process that people go through, it’s not mathematical calculus. It can’t be summed up with an equation. That is, I think, the frustrating thing. When you look at 2015-2016, what I just suggested in terms of our international creditors and current holders of Treasuries who are very happy holding those Treasuries because they are very liquid, when they try to get in front of the Fed, and the Fed’s exit strategy, you are likely to see something that is a market event, which doesn’t fit any economic calculus. It is a little bit like a bank run. What caused it? And then, what were the subsequent events which reinforced it and made it a fait accompli?

Kevin: Dave, we were talking about economics and the equations, but actually, there is an equation that has been used since the 1930s, from John Maynard Keynes, that talks about decreasing unemployment, or, in other words, employing more people, by increasing consumption. The printing of this money, these currency wars and printing money, and trying to be more competitive, all of that really is a way of trying to keep people fully employed. Let’s look at employment in America right now. It’s barely holding on, even with all of the printing.

David: But you are talking about the FOMC’s calculus being related to a certain set of assumptions, or presuppositions, which are inherently Keynesian. In other words, we are going to fix the employment issue by stimulating consumption, and we are going to stimulate consumption by creating enough credit and liquidity to do so. It’s an inherently Keynesian problem, and there are a number of systemic weaknesses that get built into the system on that basis.

And the Keynesians love the clean math of it. If you study John Maynard Keynes, you won’t see a single math problem or equation in his book. It’s basically the neo-Keynesians who have taken his ideas and tried to turn them into a pseudo-science, and now they’ve got the math problems to prove that Keynes was right. If your assumptions are right, perhaps. But if your assumptions are wrong, that’s where you end up with a tremendous amount of travail.

Kevin: Speaking of assumptions, granted, they are printing money, and they are saying yes, they are starting to add jobs. But a lot of those jobs, Dave – that’s not the whole story, is it?

David: In the last 5 months, 73% of the new jobs created were in government.

Kevin: They don’t produce anything.

David: Think of it this way. Coming into the election you have a major push in terms of jobs and employment.

Kevin: But three-quarters of the new jobs that were added in the last 5 months don’t produce anything.

David: You’re talking about 600,000 votes – I mean jobs – coming into the election. Talk about election gaming, par excellence. When you stand back, look, and say, “What is really going on here?” You realize that Jack Welch was right, that they absolutely were playing games with the employment numbers in September and October coming into the election.

And guess what? The BLS just restated and lowered the employment numbers for September and October. They had to revise them lower because they had been playing games in those two months leading up to the election. “Oh, Jack, let’s print an apology.”

No, you’re not going to see that from the news media. They castigated him, made him seem like a fool. How could he question the Bureau of Labor statistics? These guys are good with their math. They are good with their numbers. Is anyone paying attention after the fact? You should be.

Kevin: If employment was really as good as it looks, let’s say that it wasn’t just government jobs, but you wouldn’t have 47 million people on food stamps right now. I remember when I was growing up that food stamps were something that were very rare, maybe 2-3% of people back in the 1970s were on food stamps.

David: In the 1970s, it was 1 out of every 50 Americans that was on food stamps – 1 out of 50. The most recent increase was 607,559 people newly enrolled in food stamps. That brings us to 47.7 million participants and that is 1-in-6½ people in America. Again, the 1970s had their fair share of a rough patch. We had a pretty nasty recession for several years in the 1970s. Inflation was an issue. But there was 1 in 50 Americans on food stamps. Today, it is 1-in-6½. That is astounding. Since 2001 spending on this particular program has quadrupled, and it has doubled just in the last four years.

Kevin: Everything is spiking at the same time that we are hearing this fiscal cliff discussion that is going on.

David: Yes, this week we remain on the ping-pong table, if you will, the fiscal cliff ping-pong table. You have the GOP and you have the Democrats. They lob the ball back and forth hoping they won’t be the ones who are blamed for the outcome, whatever the outcome is.

Now, what is the fiscal cliff? In brief, law-makers recognized, a number of months ago, their inability to negotiate a budget deal and that had gone on for over 18 months, so they chose to pressure themselves, going into the new administration, with indiscriminate budget cuts at year-end. We’ll get it solved if we know that there is the Sword of Damocles hanging over our heads. And lo and behold, they are having a tough time doing it.

Kevin: It reminds me, when you are kid, somebody says, stick a needle in my eye if I don’t do it. Well, the needle is just about to go into the eye. It’s inconvenient though, here we are at Christmas time. Don’t the guys who are negotiating this have families at home that they want to get back to?

David: Several points are worthy of note. One is that the timeframe chosen was instantly awkward, because neither party wanted to work on the issue prior to the election, playing cards which could, in fact, jeopardize various political races, including one for the White House. So even though year-end sounded like a good idea originally, this year being an election year meant that the budget overhaul was untouchable until the mid-November period, leaving just six weeks for wrangling which they had hitherto found un-resolvable for a multi-year timeframe. It’s astounding.

Number two is that you have the motivation to do something. It is there now. The nature of the cuts, again, going back to that word indiscriminate, it means that a lot of pet projects are going to get nicked, and that the political blow-back from constituents in the midterm could be very unsettling for a lot of politicians. So something is likely to be announced, though we would suggest that it is only enough to avoid the automatic and arbitrary hatchet.

Kevin: You said something to me last night that really hit me. You said that these cuts are across the board. So let’s say that they are cutting 17%, for instance, in the navy. That is cutting cleaning fluids for bathroom cleanups by 17%. But it is also cutting ammunition, radar, and fuel. So this is one of those things like a piece of salami. You don’t really choose what part you are going to have, you just slice it.

David: Right, and that’s what is awkward for these politicians, and that is what they have created – the awkwardness around what it’s too painful to do, and what it’s not very responsible to do, therefore we will get off our duff and do something. But guess what they were doing, actually? Playing politics through the election, and they didn’t leave themselves enough time to put something together that would actually be a long-term working solution looking at what the cores issues are that we have had. We’ve been running a budget deficit of over a trillion dollars a year for four years in a row. We’ve increased the national debt. This week – this week – we will exceed the debt ceiling – again.

Kevin: So they have to come up with another decision – are we going to be able to poke through that again?

David: Wednesday of this week we will already be through it, and there is no discussion on it. So the issue is, we will borrow from the “Social Security” trust fund (not really a trust fund, just a slush fund, if you will) for any political purpose it can be used for. Did you realize that? Have you realized, they can use Social Security funds for anything they want? Because using a unified budget, everything goes into one pot, in terms of revenues, and you pull out of that same pot for any expenditure. It doesn’t matter. The idea that we have a trust fund is a misnomer. It’s a total misnomer.

Kevin: But let me ask you a question. Are we going to sit down and say, “Okay, our budget this year is this much, and we’re going to spend this much on these different programs?”

David: No, that’s not true! That’s not true. We haven’t even come up with a 2013 budget. What are the issues we are facing here? We have a “fiscal cliff” which we will probably solve, which isn’t really a solution, sounds a lot like what we have had in Europe. “Here’s our solution, which isn’t really a solution. We’ll be back at the table in six months, but at least we have absolved the crisis in the marketplace today.”

That’s the same kind of cycle that we are entering into here in the United States. It’s the fiscal cliff. Then we have to come up with our budget for 2013. What exactly are we going to spend? What are we going to be pinned down to, spending this and no more? We don’t even have a budget for 2013.

Kevin: That’s amazing to me because every family has to budget their finances. We can’t tap into Social Security. I can’t. Can you?

David: No, no. We don’t have the collective slush fund that we can draw from for other purposes.

Kevin: Leaving the government for a second, you’ve got corporations right now who are realizing also that debt is extremely cheap and they are utilizing that for advantage at this point.

David: Right. This will be an interesting thing, because honestly, when you are looking at 2013, it is going to be impossible to have a 2012 encore event. In other words, earnings in the S&P hit records in 2012. Profit margins, actually, were much better. Even though earnings were the best they have ever been, profit margins were actually much better back in the 1950s and 1960s, so that the earnings gains have had a lot to do with efficiency, not necessarily expansion of business, efficiency gained from laying people off, having one person do two people’s jobs.

There has been a tremendous amount of efficiency. Corporate America is run better today, arguably, than it has been in 20-25 years, but companies are, right now, buying their shares back in droves, and that is going to create an interesting dynamic for 2013, because, as you mentioned, with interest rates set below an equilibrium level, the Fed has begun to alter the investment landscape in yet another way. Debt is cheaper than equity. Corporate executives are issuing IOUs, and with the proceeds of those bond offerings they are turning around and buying back company shares.

The consequence in 2013, for companies that are actively buying back shares, is an improvement in earnings per share. Even if revenues and earnings were off next year, if you sufficiently reduce the number of shares outstanding, if you look at the basic math here, earnings divided by the number of shares outstanding, you have your total earnings per share, and you can actually have an increase in earnings per share, even with the decline in revenue.

Kevin: David, last week when we talked to Steve Forbes, he talked about the pricing mechanism being all out of whack because of what the Federal Reserve is doing. You can’t really determine the true value of something based on these artificially low rates.

David: And as strange as it may seem, share buy-backs by corporate America illustrate something very important. Actually there are two things that can be illustrated here. First is how the Fed’s price controls in the Treasury market distort various asset classes, including stocks, and second, how companies can gain public perception.

In other words, we are doing better than we were in 2013. Our earnings per share have increased from 5 cents to 7 cents. Well, if there are less shares outstanding, you had better darn well have improved your earnings per share. Otherwise your business is actually imploding. But if you look only at earnings without seeing various shifts in the balance sheet, you are likely missing those salient details of company financial management, or I guess you could even call it manipulation. That is the right description.

The trend of manipulating the numbers in this way, and in a thousand other ways, will someday be understood by mainstream investors, and it is going to cause sufficient disgust to drive them away from equities. For one reason or another, we think that this will happen, and you are going to have a generation of investors who don’t want to look at stocks again.

Kevin: If you think about survival of the fittest, business actually does show that. They make decisions based on obstacles that are in front of them. From 2008, 2009, 2010, 2011, we have seen these companies get leaner and meaner, but they see higher taxes coming down the board, so what about dividends, Dave?

David: I love this! This is classic. You have central planners who are saying, “We need more in terms of revenues. We’re going to increase taxes here, and there, and here, and there.” And here’s the market dynamic. You have special dividends. 173 companies have offered special dividends. This is up 140% from last year, and these are special dividends before the dividend rate increases…

Kevin: Right, at the lower tax rate.

David: 2012 it is 15%, 2013 it is 43%. So, 150 of these have actually been in the last quarter, with a total of about 20 billion dollars in dividends being paid out prior to the increase.

Kevin: Warren Buffet was asking for taxes to go up, as if to say, “You know, I may be rich, but by golly, I sure am willing to pay more taxes.”

David: (laughter) This is a man who says taxes should go up. But guess what? He is receiving 17 million dollars, in terms of a dividend payment, from the Washington Post, and I’m sure he will be donating that to charity.

Kevin: You mean, here in 2012?

David: Yes, of course. The Washington Post announced a special dividend, and he is a major share-holder, and his portion of that dividend is 17 million dollars.

Kevin: So he’ll pay his taxes before they go up, which he said he wanted to pay after they went up.

David: Warren Buffet does talk a great deal about reforming the income tax in the face of his vast fortune, which I find ironic, because he earned his money, not in the form of income, but through capital gains. It is a much more tax-efficient way to grow wealth, one, by the way, that is not objectionable. What is objectionable is the hypocrisy of the Oracle of Omaha. Well, maybe it’s not objectionable, but just annoying.

Kevin: The thing is, there is a moral to the story. Businesses will adapt. They will change. You have these central planners who say, “You know, let’s just go ahead and raise taxes up to beyond 40%.” Well, companies are going to maneuver around that, or change, or leave. There are countries where people are just leaving because the tax rate is too high.

David: Precisely. You push too hard, and you are going to get far less than you had hoped for. People operate on the basis of incentives, and if you reach beyond a reasonable level, people will change their lives, and, in essence, adapt, in order to accommodate the changes so that they are not impacted as greatly. Think of the British. They raised, a few years ago, their top marginal rate to 50%. Now they are lowering it again in the wake of two-thirds of British millionaires pulling up stakes and relocating outside of Britain.

Kevin: It’s funny, you hear an awful lot of British accents from the rich, but they’re not in Britain right now.

David: (laughter) Well, the companies are issuing special dividends, which is essentially accelerating 2013 cash flows into 2012. The result will be higher dividend rates next year, on less dividends, and less total revenues. Good job. Central planners are always geniuses when it comes to figuring out how to increase revenues. This is why if you don’t understand market dynamics you are always going to be at odds, as a central planner, with real results.

Kevin: And you have to look at who these central planners are, and what their background is. Not all of them are just squeaky clean. I’m thinking about Italy right now.

David: (laughter) The saga continues. Is everything cleaned up there? No, hardly anything. They’ve made some progress? Yes, they’ve made some progress. They are further along through the crisis cycle than we are, and frankly 2013 is just the American entrance into our cycle of crisis. If you really want an appraisal, 2008 was just a warm-up for what we have in the United States circa 2013-2016.

But I digress. Berlusconi. Remember the name? He resigned in disgrace in 2011. But he has had a Martha Stewart makeover in literally a matter of months. Does anyone remember that the homemaker was buried in insider trading of stocks?

Kevin: Yes, I remember the Martha Stewart thing, and now she has more magazines than she had before. How about Berlusconi?

David: Can you remember what he did to lose the confidence of the Italian people? It doesn’t matter! The Italians can’t remember either. This is so bread and circuses. Entertain us. We’ll forgive you. The mob has offered its peace to Berlusconi. Actually, I think what he knows, because he is putting in a new bid to be the Premier again in Italy, is that he can manipulate the media sufficiently to block any competition.

Kevin: So forget about the maid in New York.

David: No, no, no. That was the other Italian. No, the maid in New York, Berlusconi’s maid, we haven’t talked about that yet. (laughter) Maybe that’s a 2013 tabloid. But the reality is that he will manipulate the media, and will block any competition, and win on the basis of airtime campaigning. Should he win? You will know that there is yet another country where democracy has entered the sixth circle of hell when he wins, or if he wins. You remember the sixth circle of hell from Dante?

Kevin: What is funny is, you are quoting another Italian – Dante.

David: (laughter) Of course, of course. A countryside of pain and anguish with the tombs of heretics. Who were some of the heretics that were in the sixth circle of hell? You had the Epicureans, who denied the afterlife and lived for temporal pleasures. Hello! This is Italy all over again! I’m sorry, I hope those of you Italian-Americans, and my wife is Italian, will take this in stride and hopefully, not be insulted.

Kevin: Don’t you wonder, though, what Dante’s commentary on the current situation would be?

David: Honestly, this is Berlusconi’s Italy. The only thing that we can’t figure out is how Berlusconi escapes the eighth circle of hell. Remember, that was for fraudsters and crooks. This is really the nature of democracy any more. It is a question of what pleasures you offer the people.

Kevin: Yes, David, we have talked about this before. Democracy, over time, the more and more it starts to realize it can vote in gifts and favors and free things for itself, that’s the way it goes. We have Mario Monti in there, and people who are watching good economics are looking at Mario Monti. This is a guy who reads Hayek and is actually trying to do something long-term favorable, not short-term free.

David: Monti is probably the best thing that has happened to Italy in a long, long time. But what we had with Italy prior to Monti, and what they are going back to, in all likelihood, is really what we have in the United States. Again, it is a democratically elected leadership that is in vogue, and this really does fit well somewhere between the sixth and eighth circle of hell. It’s easy solutions, and it’s pleasure for all, at no cost.

Kevin: In the long-run there is.

David: Of course, the iron tombs of the heretics await. That’s what you have in the sixth circle. But democratically, these people just say anything people want to hear. And if you hear what you want to hear, you can obviously forget their past, and bring them back in.

That, I think, is ironic, because that’s the nature of democracy, and it is one of the things that we illustrate in this year’s DVD. We’ll have the last one out in January, the third DVD in a series, The Fuse is Lit, and it is titled, “An American Reckoning.” We start with a quote by Alexander Tyler. “Democracy cannot exist as a permanent form of government.” It only exists until the voters discover that they can vote for themselves largesse from the public treasury. From that moment on, the majority always vote for the candidates promising the most benefits from the public treasury, with the result that democracy always collapses over lousy fiscal policy, and it goes on from there. This is where we are.

Monti brought in something very unique into Italy, even if for the short term. If Berlusconi wins, I would bet that the Italian economy sinks as fast as that of the Spanish, maybe not quite as fast as the Greek, but Berlusconi brings corruption to every level of Italian politics. I never thought I’d say this, but the benefits of a bureaucrat, going back to Mario Monti, are there because his ambitions were never political. He wasn’t elected, he was chosen, and he has chosen not to stay the full term. His ego is tame, by comparison.

Kevin: He was a hesitant leader. They had thrust him into the position and he did a good job.

David: But real work has been done on his watch. With Berlusconi, you are bringing the fox right back into the hen house. The fiscal mess which is Italy was not caused by Berlusconi, but it was certainly made worse by him. That is hardly the kind of partner that the EU needs at this moment in time, trying to fix the EMU, deal with fiscal issues, and deal with political differences between member states. You don’t need someone with a large ego who is prone to corruption as a leader in Italy.

Kevin: David, for the person who is listening right now who is saying, “All right, they’ve talked an awful long time about Italy. I’m here in America, or I’m in Asia. How does Italy really affect me?” I think what you are saying is, this is the trend worldwide.

David: This is where we are on a global basis, not only in Italy, not only with the ECB, now talking about the monetary mandarins, if you will, the ECB, the Bank of England, the Bank of Japan, the Bank of China, and the Federal Reserve. What you find is that deflation is not acceptable in a democracy.

Kevin: Therefore print money.

David: Well, it makes employment more volatile if you accept deflation, and thus politics becomes inherently unstable, so it is not a policy choice that is preferable in a democracy, and it puts negative pressure on consumption. So deflation will be fought tooth and tong, and it is being fought tooth and tong around the world by not only the politicians, but also the support they are getting from the central bankers.

Inflation, on the other hand, is the acceptable course in a democratic system, because, number one, people don’t understand it. That goes back to John Maynard Keynes. It’s a policy that allows for political cover and ultimately, scapegoating. If we end up fomenting a true inflation, you know who will be the first to be blamed? Big oil! Oil prices now are at $150. These guys are making a fortune. They are the cause of the inflation. Don’t you see it? It’s big oil. There is that scapegoating tendency, but it’s because inflation is a monetary tool. As a political tool, it is something that offers cover for the politicians, and their bad fiscal policies.

Kevin: David, we have been trained in our generation, especially since 1971 when we went off of the gold standard, that prices just have to go up every year. Things get more and more expensive. Speaking of not understanding it, no one really asks the question as to why.

David: The other part of inflation is that it is a choice that sets immediate benefits in front of us, and of course, there are long-term consequences. That is a politician’s dream, when you can have some sort of a benefit today, with the consequences being after you are out of office.

That’s why inflation is a brilliant tool for the policy-maker to adopt. It’s fascinating. Go back to conversations that Janet Yellen had with Alan Greenspan when he was in office. Greenspan said, “No, I don’t think 2% is an acceptable target for inflation. We’re supposed to have stable pricing. That is our mandate. 2% would be accepting inflation as our mandate, and it’s not, because stable pricing is our mandate.” And yet, of course, he lived with those inconsistencies and put policies in place which were highly inflationary.

You have, today, a form of an increase in taxation, without changing the code, and it’s happening universally. This is an Italian problem. This is a French problem. This a Greek problem. This is an American problem. Why do we talk about Italy? Coming to a theater near you, that’s why, because what we have is the same kind of monetary and fiscal mess. The Keynesian model has harnessed the politician’s temptation to stabilize employment and control or try to influence consumption, and they are pushing that model as far as they possibly can.

Kevin: We seem to have the perfect storm coming together. We have unemployment, which is high. We have the costs of things going higher and higher and higher. We have an equities market, and all the investment markets right now, if they are yielding anything, it’s from a false premise, and it is coming from artificially low interest rates in other areas.

So in reality, the person on the street, or the waitress in a restaurant, for example, may not be working just one job, she may be working three jobs. Or the person who is right now living on credit cards. We talked to a young lady last night who has started to realize, even though she has several jobs, that she is starting to live on her credit card, and she said, “Wait, I’ve seen that kind of destruction in my family. I have to do something different.”

David: The number of Americans who were sobered for the first time in 2008 by a change, an unfortunate change, an unexpected change, are looking ahead and have some caution still inside of them. 2008 was, I think, for many Americans, preparation for what lies ahead. The challenges of unemployment, the need to work extra hours to make up for a spouse’s lost wages, that has instilled a basic insecurity into people.

Getting caught up on the bills here in the last couple of years has been good, making sure that the kids are taken care of, knowing that things are not as easy as they used to be, these are the realities that the average American is living with. There is a sense of foreboding, and it goes beyond the fiscal cliff. It goes beyond who is leading the country. Clearly, it goes beyond who is leading the country in Italy.

There is a sense that harder times are coming. You see people realizing that they can’t do what they were doing. As you mentioned, someone realizes that credit card balances are rising, and this is simply to cover the basics. This is not extravagant spending. You watch family members go through difficult circumstances and struggle for years to pay off debt, and you know that you have a problem. You recognize the problem, and you start working more hours, or you work two jobs.

The question is, as the men and women in the street deal with these realities, how long does it take for their experience to translate into a different body politic? In other words, you look at your finances and realize you can’t just put more on the credit card, you are going to have to work more hours, or you are going to have to get a second job, to make sure that you don’t get into the debt trap. You know that the debt trap is a dangerous one. It’s a quick process to get ensnared in, and it is a very painful process, and it takes a long period of time, to get out of it.

Kevin: I’m sure many listeners are sitting there saying, “Yep, I did that the hard way,” and we’ve also done it the hard way a number of times.

David: And so, as individuals, we’re willing to do the hard work to fix the problem. The fiscal cliff is just one illustration of a lack of restraint, in which our government has done the same thing. We’re back on credit cards again, and it’s easier to spend doing that. Again, future credit. “We’ll pay this off tomorrow, we’ll pay this off tomorrow, we’ll pay this off tomorrow.”

And yet, we need to hold them accountable. The only way we can do that is by changing the expectations that they understand. What is it that they are supposed to be doing? How is it that they represent us? Is it just to bring more money back to the state from the tax revenue coffer? Or do they have a different mode of operation, moving forward? They don’t today.

It’s going to take us at least one election cycle, maybe two or three, to communicate from the hoi polloi, you and me and the rest of us, that we have a different set of expectations. It’s actually a very simple set of expectations. It’s that you manage your finances like we have to manage ours, as if there are consequences to your actions.

Kevin: David, don’t you think going into debt and continuing that cycle is just a form a denial? For example, I hate cleaning my garage, and for whatever reason, it doesn’t stay clean. But when my wife can’t get her car in the garage, that’s when the garage gets cleaned. So there has to be a breaking point here, whether it’s a fiscal cliff, or whether it is just an outright denial of our creditors buying our debt anymore, there has to be, like you said, this cusp event that forces discipline.

David: The first change will be culture changing, and it will be the common man changing, and ultimately, the question of if art reflects culture, or if culture reflects art. Our government reflects the people. And we have, for decades, spent too much money, and our government reflects individuals having done the very same thing. Now, individuals are learning a different way. It is going to be some period of lag time – 5, 10, or 15 years – before government is clued in that we want and expect something very different. That’s what we have to fight for. That’s what we have to hold as an expectation, that they operate by the same set of rules.

Kevin: I think it is important to talk like we did a few weeks ago, Dave, that this is not a hopeless end to the world. What we are talking about is that it is an end to the credit living that we have been doing, this debt living, but it also sets the next generation up for something that could be very, very profitable, and very, very prosperous.

David: When you look at the nature of a credit cycle, it is a boom-to-bust cycle, and there is nothing wrong with a bust. It cleans the decks, if you will. It clears out the system. For all of the inefficient businesses that have been run on the basis of government subsidies, do you know what you do? You allow them to fail, and you have new businesses with great entrepreneurs who are willing to take reasonable risks and work their tails off to succeed. The decks are clear, the field is open, and you can bring your ideas to the marketplace.

Kevin: And for those who saved. Look at John Templeton, the advice that he had. “Save 50-51% of your income if you can do that, and then buy for pennies on the dollar when this occurs.”

David: That’s right. So, what we see is not bad news, we just see a part of the human cycle that, yes, does include tragedy, to the degree to which you allow it to include you. What is that degree? We have begun a discovery process. 2008 was probably the most eye-opening, as we looked into the gates of hell for the first time.

If you have read through Divine Comedy, Dante’s book, it didn’t being with paradise. It began with hell. You went through purgatory, you went through hell, and then you discovered paradise, and your appreciation of paradise was, in part, because you understood the contrast. You understood that the present pleasures that were promised, and the people who suffered in the context of that sixth circle of hell understood it wasn’t so meaningful in light of eternity.

Again, this is not an eternal message, as much as it to say, we do have something on the other side. Crisis does not define our generation, but it may define the success of this generation on the other side of crisis, and that is particularly interesting to us, as we see the right kinds of leaders born through this particular period of time, and offering a very different America, one that we are excited to participate in.